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Friday, May 16, 2008

Taxing Phantom Income

Imagine working for a company for years, participating in the company savings plan, taking $2000 out of the plan, and then getting hit with a tax bill for $50,000! This actually happened to a woman who worked for $14 per hour for JDS Uniphase. Sadly for her and her husband, she wasn’t one of the JDS Uniphase employees who had their tax bills forgiven late last year.

I explained the problem first here and here. It’s hard to understand why the government would want to tax people on money they never actually received.

The problem is related to how employee stock options are taxed. The gain in the value of the options can’t be offset against any losses on the stock acquired with the options even though both are taxed at the same rate. Many company savings plans are structured using stock options, and so there can be problems here as well.

This problem affects me as well. I will be hit with a 6-figure tax bill if I ever sell stock in my former employer, even though I will get only one-third of this amount from selling the stock. One solution is to never sell, but there is a deemed sale if I leave Canada to live elsewhere or if the company is bought out. So, I don’t control my fate.

A perverse aspect of the tax law is that you can offset stock option gains with capital losses on the acquired stock in the year that you die. I will be able to handle the tax bill if the company is bought out, but not everyone facing this problem is this fortunate. What a sickening situation to have to die before the end of the year to avoid financial devastation for your family.

Patrick: You're OK as long as you are holding the options. The tax liability comes into existence when you exercise the options and receive stock. But, you don't have to pay this tax until you sell the stock. If the stock drops before you sell it, you still owe the taxes on the higher value -- money you never received. And you can't offset this stock option gain with the capital loss that results from selling the stock after it has dropped. The situation is absurd.